Protecting Margin in a Low Interest-Rate Environment

Andrew Paolillo Icon
Andrew Paolillo

Cash on member balance sheets has grown in response to the uncertain operating environment. The yield curve is lower and flatter as compared to the last time short rates converged toward zero. Advance solutions exist to support margins and mitigate risk during times of low interest rates.

Unprecedented Activity

The initial onset of the COVID-19 pandemic created a unique set of challenges for financial institutions in the first quarter and the months that followed were anything but normal. For perspective, let’s look at the unprecedented build-up of cash on bank balance sheets. As the chart below shows, cash held by commercial banks spiked by more than $1.5 trillion, an increase of nearly 100% year over year. This erased over five years of gradually declining cash balances, and then grew by another 15% ─ all in a matter of weeks.


The uncertain credit environment, a record surge in deposits (including unused Paycheck Protection Program (PPP) funds) and the slowdown in non-PPP lending activity have all contributed to this abundance of caution. As the economy begins to recover, the question becomes, “When do members feel confident that the time is right to resume deploying assets rather than building cash cushions?”


As opposed to most of the last year and a half, holding cash has become relatively expensive due to current conditions. The chart below shows the path of the five-year Treasury yield and the Effective Federal Funds Rate since the beginning of 2019. As longer-term rates began to fall and eventual cuts to short-term rates were anticipated, holding cash (using Fed Funds as a proxy for the yield on cash) produced more income than moving out the curve.


“The unknown right now for many members deciding on the pace and magnitude of deploying cash reserves is whether the longer tenors of the yield curve will follow the path seen last time, suggesting that taking interest-rate risk is the way to go, or whether the lack of slope in the curve presents an unappealing risk/reward profile, with the  prospect of ample room for steepening.”

At its peak in the third quarter of 2019, cash offered yields 80 basis points higher than Treasurys. But since the abrupt rate cuts in March, that relationship has flipped. With Fed Funds near zero, five-year Treasurys have yielded upwards of 40 basis points more than cash. However, given the uncertain outlook for the economy and the markets, this opportunity cost is something that most prudent balance sheet managers are willing to absorb.

The Shape of the Yield Curve

While short-term rates being near zero may be reminiscent of 2008, the rest of the yield curve looks markedly different. At the onset of the last crisis, long-term rates were considerably higher. The chart below shows the spread between the three-month Classic Advance and the five-year Classic Advance in the period following the rate cut to zero back in 2008, and again now in 2020.


The steepness in the current curve is at just 48 basis points compared to the greater than 250-basis point spread for the same timeframe in 2008 to 2009. In fact, in the seven-year period between 2008 and the first rate hike in 2015, the three-month vs. five-year spread never reached a level as low as it is now. The average of 186 basis points was nearly four times current levels.


The unknown right now for many members deciding on the pace and magnitude of deploying cash reserves is whether the longer tenors of the yield curve will follow the path seen last time, suggesting that taking interest-rate risk is the way to go, or whether the lack of slope in the curve presents an unappealing risk/reward profile, with the prospect of ample room for steepening.


In a press conference on June 10, 2020, Federal Reserve Chairman Jerome Powell noted that “we’re not thinking about raising rates,” with the consensus from Federal Open Market Committee participants that it will remain that way through 2022. With short-term rates seemingly anchored, what happens further out the curve will ultimately drive profitability.


Funding Strategies in a 0% World

Depending on your institution’s unique circumstances, there are ways that the flexibility and range of FHLBank Boston advance solutions can be used to navigate this extremely challenging environment. A low and flat curve is not an ideal setup for many financial institutions, but here are three approaches that can help improve margins and manage risk:

Strategy #1: Modest Advance Extension into a Flat or Inverted Curve

At such low rates, every basis point counts that much more. The slight inversion between three-month and 12-month Classic Advances affords members the ability to seek out the cheapest point on the curve, with added protection against a near-term steepening of the curve. With the lower end of Fed Funds already at zero, the repricing benefits of short-term liabilities is relatively muted.

ADVANCE TERMRATESPREAD VS.
3-MONTH CLASSIC
3-month Classic0.45%
6-month Classic0.46%0.01%
9-month Classic0.47%0.02%
12-month Classic0.41%-0.04%

Strategy #2: Forward Advances to Meet Future Asset Growth


As the economy emerges from the COVID-19 crisis, many economists are projecting the possibility of significant GDP growth in late 2020 into early 2021. While the need for wholesale funding has decreased given increased cash levels, it may swing in the other direction during an economic recovery, especially for those depositories that have seen a significant surge in flight to quality deposits and/or PPP activity.


Also, in an economic recovery, the long end of the yield curve could rise as investors flee safer investments like long-term government bonds and seek out opportunities in riskier assets. Forward-starting advances offer the ability to benefit from the current low and flat yield curve while pushing the disbursement of funds to a period when the need for funding may be greater. On June 24, 2020, a two-year Classic Advance for disbursement 12 months forward was priced at 0.69%, just six basis points more than a two-year Classic Advance where the proceeds are received immediately.


ADVANCE TERMRATESPREAD VS.
2-YEAR CLASSIC
12-month Classic0.43%-
2-year Classic0.62%-
3-year Classic0.68%-
2-year Classic, 12-months Forward0.67%0.05%

Strategy #3: Short-term Funding to Align with the Federal Reserve’s Guidance


If your institution believes Chairman Powell’s assertion that short-term rates will not be rising anytime soon, then funding tied to an overnight index can be advantageous ─ particularly when it offers cost savings versus other short-term alternatives.


The SOFR-Indexed Advance has recently been pricing with an initial rate of five to 15 basis points below that of short-term Classic Advances. As the SOFR index has exhibited an extremely strong correlation to the Effective Federal Funds Rate, if Fed Funds remain anchored for the foreseeable future, it is likely that SOFR will too, resulting in the advantage of the SOFR-Indexed Advance offering the opportunity for interest expense savings.


ADVANCE TERMRATESPREAD VS. DAILY
CASH MANAGER
Daily Cash Manager0.45%
1-month Classic Advance0.45%0.00%
3-month Classic Advance0.45%0.00%
3-month SOFR-Indexed Advance0.36%-0.09%

Flexible Funding

Recent market conditions have created many new challenges for FHLBank Boston members. Our Financial Strategies group can work with you to identify the funding solutions that best fit the unique needs of your balance sheet. Please contact me at 617-292-9644, andrew.paolillo@fhlbboston.com or your relationship manager for more details.


FHLBank Boston does not act as a financial advisor, and members should independently evaluate the suitability and risks of all advances.

Andrew Paolillo Icon
FOR OUR MEMBERS:

Strategies + Insights delivered to your inbox

Subscribe to our daily email today.
Subscribe

​​MORE STRATEGIES + INSIGHTS